“Buy-the-Dip” Gets a Stiff Test

There is nothing like a strategy that works far more often than it doesn’t.  In recent months, and for the better part of five years, “buy-the-dip” has been a generally reliable winner for many active traders.  After a pre-market rally attempt stalled just after this morning’s open, we need to question whether reflexive buying should remain the strategy of choice in all circumstances.

Let’s be clear – there is absolutely nothing wrong with buying on dips.  It certainly fits with the concept of “buy low, sell high”.  I imagine that there were speculators in Mesopotamia or ancient Greece who bought grain or other commodities when prices fell; why shouldn’t modern traders do the same?

That said, there are some important considerations that seem to be overlooked from time to time.  First and foremost, one needs to consider why a particular stock or commodity is being sold.  Before hitting the buy button, consider whether the fundamentals changed substantially.  It is one thing to buy something whose underlying value has not changed.  That is like shopping when the store is having a sale – like buying the same shirt for less money than you might have paid last week.  But it is another thing entirely to buy something without considering why the market is valuing that product less favorably than it was before.

That is where the second consideration arises, whether the current, lower price is actually appropriate.  Clearly, it is a good buying opportunity if a fairly valued stock gets cheap; if that stock goes from highly overvalued to somewhat less overvalued, it might still be too expensive to merit a purchase.

Along with dip buying, trend following has become highly popular.  The two often go hand-in-hand.  If a commodity is in a well-defined trend, and it slips from the high end of the uptrend to the lower end, it is of course understandable why buyers would want to step in.  But what happens if that trend breaks?  It makes less sense to buy reflexively than to let the market do some price discovery. 

When I was an over-the-counter market maker, we had a saying “wait until it finds a level.”  It meant that we didn’t necessarily want to be the first buyer on a dip when the selling felt heavy – it made more sense to try to determine where there was new demand before stepping in.  That could be at obvious support levels, or it could simply be when large buyers make their presence known.  That strategy tries to balance FOMO, “fear of missing out”, with actual fear.  You may miss the bottom, but you’re also less likely to buy it well before the bottom is reached.

In the current environment, we still see a preponderance of FOMO relative to actual fear.  That’s why a move like last week’s seemed so out of character.  We’ve gotten used to ever-muted dips.  As buyers have raced to capture dips before their competition, the dips become smaller.  A large drop means that (1) the initial dip buyers got swamped by a wave of selling, and (2) a more meaningful change in market psychology might be afoot. 

Friday’s drop had both characteristics.  We won’t know for some time whether the changes in consumer sentiment were spurious and potentially overblown or more lasting in character.  Yet that is why today’s test of “buy-the-dip” is meaningful.  If Friday’s dip was simply a blip in the market’s uptrend, then the buyers should benefit.  But when we see an early test get swallowed up by more motivated sellers, it should make us consider whether a modest re-rating of fundamentals has truly occurred.  The latter could be a more lasting concern.